From the horse's mouth....
Oil's surge: what's behind it and what it means for Saudi Arabia
Brad Bourland, Chief Economist & Head of Research Jadwa Investment, Riyadh, Saudi Arabia
Oil prices have hit a series of all-time highs and touched $120 per barrel in late April despite clear signs that the global economy is slowing. Demand and supply fundamentals have supported much of the run-up in prices in recent years, but the recent upward movement has been the result of investors using oil (and other commodities denominated in US dollars) as a hedge against the falling value of the dollar. Higher prices have not had too great an impact on economic growth so far because most consumers have been sheltered from the rise. Retail prices of fuel in emerging markets are generally fixed at low prices, those in Western Europe are heavily taxed, while in the US refiners have been absorbing some of the higher fuel costs with reduced profit margins.
Given the momentum within the market there is no reason why prices can not go on rising over the near term. However, we think that prices are now well beyond those justified by the fundamentals and as the dollar stabilizes we think oil prices will end the year near $70 per barrel. Nonetheless, with WTI averaging over $100 per barrel over the first four months of the year we are revising up our oil price forecasts. We now expect WTI to average $90 per barrel this year, $76 per barrel in 2009 and $85 per barrel in 2010.
Saudi Arabia's economic performance will benefit from high oil prices. This year we expect the current account surplus to hit an all-time high and nominal GDP growth and the budget surplus to be exceptionally robust. Lower oil prices over the following two years will make some of the headline numbers look less impressive, but the underlying momentum within the economy will strengthen, with inflation remaining a problem.
Why the oil price is going up
Oil prices have risen dramatically over the last six years. West Texas Intermediate (WTI) touched $120 per barrel in late April, compared to just $19.9 per barrel at the end of 2001, an increase of around 500 percent. Growth in demand for oil outpacing growth in supply has been the fundamental reason that oil prices have risen. The chart to the left shows that in each year since 2003 global demand has grown faster than non-Opec supply, putting pressure on Opec to expand output. [See full-length PDF version for charts.]
Over the five years to 2007 global oil demand increased by 8.1 million barrels per day (b/d), whereas in the five years to 2002 global oil demand was up by only 4.1 million b/d. China has been the main source of this new demand. Chinese oil consumption rose by 2.5 million b/d (50 percent) between 2002 and 2007, as the country's industrialization entered a more energy dependent phase and the number of vehicles on the roads has surged. The second largest source of new oil demand over this period has been the Middle East, where consumption growth of 1.2 million b/d has been supported by rapid economic growth and low fixed prices. Consumption growth in the US, the world's largest oil consumer, also expanded by 1.2 million b/d.
While demand has surged, non-Opec supply has failed to keep up. The chart at the top of the following page shows that non-Opec supply has consistently fallen below the benchmark forecasts of the International Energy Agency. Regular disappointment over new supply has helped push up prices. After many years of underinvestment, shortages of technology and expertise have rapidly pushed up the costs and slowed the process of locating new oilfields and bringing their production on-stream. This is currently hindered by the global credit crunch, which has raised the cost of securing the necessary finance.
Furthermore, the climate for investment in oil and gas in Russia (which has been the main source of new oil supply over the past decade) has worsened owing to greater political interference in the sector. After rising for each of the past nine years, Russian crude oil production fell by 1 percent in the first quarter of this year. Lower expectations of future non-Opec supply growth are becoming entrenched in the market and any threats to or actual disruption of supply is putting upward pressure on prices.
Opec production has increased over the last five years. Formal production quotas have been raised from 21.7 million b/d in January 2002 to 27.25 million b/d currently (excluding new entrants Angola and Ecuador) and current output is running around 200,000 b/d above this. Opec producers also have very little spare capacity. Only Saudi Arabia has sustainable spare capacity, of around 2 million b/d. However, the bulk of this is heavy sour crude that requires complex and expensive refining that not all refineries are configured to carry out. As a result, this type of crude trades at around a 15 percent discount to WTI.
In this environment of limited surplus capacity, the effects of disruptions to supply on oil prices are more pronounced. Troubles in Nigeria, Iraq, Iran, Venezuela and Russia in recent years have all contributed to higher prices.
Inflows of capital from investment funds have also become an important factor pushing up oil prices. Oil is being used as a hedge against the US dollar and the run up in oil prices in recent months has corresponded very strongly with a persistent weakening of the dollar. The rationale for this is that oil prices are a dollar denominated investment that is maintaining, if not gaining, value against other currencies even though the dollar itself is falling. In addition, with global stock markets and interest rates falling, oil, and commodities in general, are considered relatively attractive investments.
We think it would take clear evidence of a slowdown in demand for oil for prices to retreat. Higher oil prices are hurting the global economy, but not by as much as analysts had expected. A benchmark study by the International Energy Agency (in conjunction with the IMF and OECD) in 2004 concluded that a 40 percent increase in oil prices takes around 1 percent off global GDP. Since the end of 2002, oil prices have risen by nearly 500 percent, yet global growth last year was 4.9 percent and even with recession looming in the US, it is expected to be around 3.7 percent this year, above its 20-year average.
In part, the resilience of the global economy to the ongoing run-up in oil prices is because the price rise is the result of a shift in demand rather than a shock to supply (as was the case with the price surges in the mid-1970s and the early 1980s). In addition, the full extent of the prices rises has not been passed on to the consumer for the following reasons:
In many emerging markets gasoline is sold at a fixed price that is not adjusted in line with movements in the global oil price. In China, for example, the retail price for gasoline has been increased by 95 percent since the end of 2002. In most Middle Eastern countries, prices have not been changed at all and in some cases they have been cut (Jordan is a notable exception; it removed all oil subsidies in February).
In Western Europe fuel is heavily taxed. In the UK, for example, tax accounts for 55 percent of the retail price of gasoline. As crude oil prices account for less than half of the final retail price (refining, transportation and other costs make up around 10 percent of the total) the impact of the run-up in oil prices on final prices is less pronounced. Since the end of 2002, the retail price of gasoline in the UK has climbed by only 80 percent.
The weakness of the dollar against most leading currencies over the last five years has offset some of the rise in international oil prices, which are denominated in dollars. For example, in euros the oil price has increased by just less than half of the increase in dollar terms.
In the US, taxes are much lower than in Western Europe (they account for around 26 percent of the gasoline price) and there has been not been a beneficial exchange rate impact. Nonetheless, the retail price of gasoline is up by only 140 percent, as refiners have absorbed much the higher costs. Margins for US West Coast refiners have plunged since the middle of last year, from over $22 per barrel to less than $6 per barrel. As a percent of the oil price the decline is even more marked.
Analysts assumed that higher crude prices would pass more directly to final consumers and this would cause inflation, leading central banks to raise interest rates and ultimately slowing economic growth. It is the lack of impact on inflation to date that explains why high crude prices have not significantly slowed global GDP growth.
A slowing global economy should put downward pressure on prices, but so far the opposite has happened. The fixed fuel prices that shelter consumers in the regions where demand is growing rapidly are unlikely to be adjusted by too much as governments try to contain inflation in the face of rising food prices. However, the rise in US gasoline prices has gained momentum in recent weeks and US oil consumption will decline this year. We also think that the dollar will stabilize as expectations of the size and number of future interest rate cuts are reduced and other leading global economies slow, reducing the flows from investors using oil as a dollar hedge.
Given the momentum within the market there is no reason why prices can not go on rising over the near term. However, based on our assessment of the fundamentals we think that prices are too high and as the dollar stabilizes we think that WTI will end the year near $70 per barrel. Nonetheless, with WTI averaging over $100 per barrel over the first four months of the year we are revising up our oil price forecasts. We now believe that WTI will average $90 per barrel this year (equivalent to $85 per barrel for Saudi crude).
We are concerned about the global economic outlook for 2009, as the impact of the fiscal stimulus and lower interest rates in the US will have warn off, but the effects of the deterioration in the housing market on employment, consumer spending and corporate balance sheets will linger. Growth in Western Europe and Japan is also likely to slow next year according to the IMF. We therefore forecast that WTI will average $76 per barrel in 2009 ($72 per barrel for Saudi crude). With the global economy recovering and the fundamental tightness between demand and supply remaining, we expect WTI to jump up to an average of $85 per barrel in 2010 ($79.5 per barrel for Saudi crude).
Implications for the Saudi economy
The upward revision to our oil price forecasts has a positive impact on our outlook for the Saudi economy. The current account surplus will be at an all-time high this year and economic growth and the budget surplus will also be exceptionally strong. The lower oil prices we are expecting in 2009 and 2010 mean that some of the headline numbers will not look as good, but the underlying picture will remain very healthy and in real terms we expect economic growth to be stronger. (A full breakdown of our forecasts together with historical data can be found in the full-length PDF article.)
We now expect oil export revenue to reach $260 billion in 2008. This compares with an average of just $43 billion per year throughout the 1990s and is equivalent to around $700 million per day (we estimate that Saudi Arabia earns $1 billion in oil revenues every day that WTI is above $115 per barrel). Non-oil export growth may slow modestly in response to lower global petrochemical prices. Nonetheless, total exports are now projected at $290 billion, compared with just $39 billion in 1998.
We have also revised up our forecast for imports owing to the spiraling cost of food imports (food accounts for around 12 percent of total imports). Higher global prices meant that the food import bill for January of this year was 44 percent higher than that for one year earlier (see In brief: Economy in full-length PDF article). Prices of many foodstuffs have subsequently moved even higher. In total, we expect imports to grow by 30 percent this year. However, this will be outweighed by the jump in oil revenues and we forecast that the current account surplus will reach an all-time high of $127 billion in 2008 (though as a percentage of GDP it will be lower than in 2005 and 2006).
The current account surplus will be reflected in a further jump in foreign assets. SAMA's holdings of foreign assets have climbed by over $10 billion per month in each of the six months to February (the latest data that is available). We expect total foreign assets (those held by SAMA and the government pension funds) to exceed $475 billion at the end of this year, up from just $73 billion at end-2002.
Higher oil revenues will also raise the budget surplus. We now forecast that the budget surplus will be SR260 billion ($69 billion) in 2008, the second largest ever. Soaring oil prices and worsening inflation are putting popular pressure on the government to increase spending. In addition to a package of measures to alleviate the impact of inflation, including a public sector pay rise, announced in January (see our February Monthly Bulletin), at the end of March the government said that it would finance a cut in the tariffs that importers pay on 180 foodstuffs, building materials and other consumer goods.
We assume that further such targeted measures are likely over the remainder of the year. Costs for the large array of capital projects the government is undertaking are also rising rapidly, but we think that the high oil prices will encourage the government to push ahead with its spending plans. Based on our revised spending assumptions, Saudi oil prices would need to average below $53 per barrel this year for the budget to fall into deficit.
By adding to money supply growth and tightening various supply bottlenecks within the economy, higher government spending will feed into inflation, which is continuing to rise at an alarming pace. Inflation hit 9.6 percent in March, up from just 3.1 percent in June of last year. Rents and food prices remain the main sources of inflation, but the price rises are now spreading. In year-on-year terms inflation picked up in each of the eight subcomponents of the cost of living index in February. This spread of inflation will complicate policy to contain it and further fuel the public's inflation expectations. We have again revised up our forecast for inflation for this year; we now expect it to average 8.2 percent.
We do not think that inflation will have too much of a negative impact on economic performance as it is the dynamism within the non-oil sector that is responsible for much of the run-up in prices. Our forecast for real GDP growth remains unchanged at 5.5 percent owing to strong growth in the manufacturing, construction, transport and communications sectors (for more detail on our growth forecast for 2008, see our January Monthly Bulletin). Higher oil revenues will allow greater government spending but the effects of this will be offset by the delays in many new projects and the impact of inflation on consumer spending.
In nominal terms, we now forecast GDP to grow by 22.1 percent this year, the second fastest rate since 1990 (higher oil prices lift nominal GDP). At $457 billion, the Saudi economy will be three times larger than it was in 1998.
The fall in oil prices we are expecting for 2009 will make economic performance look weaker compared with this year. In nominal terms the economy may not grow at all, while the current account and budget surpluses could shrink to five- and six-year lows, respectively. However, in real terms performance will improve owing to large new petrochemical facilities coming on-stream, a near doubling of cement capacity, higher oil production and the scaling up of work on various megaprojects around the Kingdom.
We expect 2010 to be another strong year for the economy as the momentum generated by the investment boom and ongoing liberalization will continue to support activity. Inflation will still be an issue, averaging 5 percent, and even though oil prices are expected to rise back to $85 per barrel, rapid growth in government spending will result in a budget surplus of only around 5 percent of GDP.
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Reprinted with permission of Jadwa Investment.
About Brad Bourland
Brad Bourland is head of research at Jadwa Investment, Riyadh. From 1999 through 2007 Brad was the Chief Economist at Samba Financial Group, formerly Saudi American Bank, in Riyadh, where he published regularly on issues related to the Saudi and global economies and the world oil market. He appears frequently in the domestic and international media and is a regular public speaker. Before joining Samba, Brad spent an 18-year career as diplomat, economist, and manager with the U.S. Department of State. During the last three years of his diplomatic career he was in Riyadh as the American Embassy's First Secretary responsible for financial affairs, where he analyzed the Saudi economy for the U.S. Government and conducted financial aspects of US-Saudi relations. Brad has his BA and MA magna cum laude from the University of Utah, and is a CFA (Chartered Financial Analyst) charterholder.